This era is over, at least for now. The Fed and other major central banks are in inflation- fighting mode and sufficiently behind the curve, so that weak data in the near term is unlikely to deter policy tightening. If bad news isn’t good news anymore, in the minds of investors, what exactly constitutes good news for the markets?
A few strong growth data points won’t suffice and could actually be bad news if they embolden the Fed to be more hawkish. The January jobs report released on Friday illustrates the point. The 467,000 new jobs far exceeded expectations, compounded by the 709,000 combined upward revisions for November and December. Distortions caused by the annual revisions and the 2020 census adjustments temper what would normally be considered a blowout result. And the 5.7% year-on-year increase in average hourly earnings fueled inflation concerns, which further raised Fed hiking expectations and rates. Given these conflicting results, equity markets appeared unsure how to react, with S&P 500 futures flat by late morning before closing higher on the day due more to technicals than fundamentals.
Instead, it’s likely that it will take a few months of good economic news to change investor sentiment that’s turned cautious; i.e., flip recommendations from “sell the rallies” back to “buy the dips.” The root of this caution stems from worries that the Fed is about to tighten policy as the economy slows and doubts about how much inflation can moderate without the Fed significantly tightening financial conditions. It will take time for those concerns to be ameliorated, which we think that they will be. In the meantime, this regime of ambiguous good news has a few investment implications.
First, market reaction to news is likely to be asymmetric: more negative for bad news than it is positive for good news. That’s certainly been the case during the 4Q21 earnings season, and the same can be said for the January jobs number compared to other strong payroll reports over the past year. This speaks to investor sentiment becoming fragile in the face of the Fed’s hawkish pivot. For equities to go higher in the near term, they will have to overcome a true wall of worry.
Second, markets are supposed to be forward-looking, but at the moment they appear to be trading on “spot” news—i.e., current data—not expected data. Omicron has temporarily disrupted economic activity, but it’s also made the data noisier, so it’s harder to judge the true direction of growth. This change in market behavior also stems from the Fed’s new policy reaction function. Pre-pandemic, the Fed started hiking rates expecting inflation and employment to reach their targets, but before they actually did. This cycle, the Fed has waited for both conditions to be met before starting to hike. In other words, the Fed is now outcome-dependent, and so too are investors. The combination of this approach and noisy data means investors seem to have low conviction that the macro situation will get better, which puts relatively greater emphasis on current data.
Third, the few months of good data necessary to turn sentiment could be starting now and may peak in 2Q22. By then economic data should be accelerating after the omicron slowdown, while the start of the inflation moderation should be evident. This dynamic could be similar to what transpired at the start of 4Q21, after the delta wave receded and 3Q earnings proved to be far more resilient than expected. It’s worth noting that those conditions contributed to a 9% rally in the S&P 500 from early October to early November after it fell 5% in September. Repeating a rally of the October magnitude will be difficult, especially with the Fed hiking rates. But it’s likely that by the spring good economic data will start to be perceived that way, providing a tailwind for risk assets. But until then, be prepared for more market choppiness.
Main contributor – Jason Draho
Content is a product of the Chief Investment Office (CIO).
Read original report – What is good news anymore?, 7 February 2022.